The Magic Formula for Commercial Services

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If you're a busy investor with more than just stock-picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's "magic formula."

Greenblatt details this approach in his enriching and funny The Little Book That Beats the Market. His strategy revolves around two factors:

  • How cheap is the stock?
  • How profitable is the company?

This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.


A cheap business and a profitable company
To find cheap companies, the magic formula looks for a high earnings yield -- basically, a company's earnings before interest and taxes, or EBIT, divided by its enterprise value. EBIT is also known as operating earnings. Enterprise value includes the company's market capitalization and its net debt. In general, the higher the earnings yield, the better. The magic formula looks for a yield higher than 10%.

To find profitable companies, Greenblatt's magic formula seeks businesses that generate pre-tax returns on assets, or ROA, greater than 25%. For example, for every $100 in assets a company holds, it would produce at least $25 in net profit. In general, the higher the ROA, the better the business.

So how do some of the biggest companies in commercial services and supplies fare?

Company

Enterprise Value

EBIT

Earnings Yield

ROA

Waste Management$25,698$2,0828.1%9.2%
R.R. Donnelley & Sons$6,098$73512.1%8.9%
Pitney Bowes$7,195$78210.9%9.6%
Clean Harbors$3,741$2195.9%10.5%
Ritchie Bros. Auctioneers$2,677$1043.9%10.7%
Republic Services$17,840$1,5818.9%8.1%
Stericycle$8,809$4435%14%
Iron Mountain$8,495$6127.2%10.1%
Cintas$5,946$5288.9%12.4%
Waste Connections$4,732$3216.8%9.6%

Source: S&P's Capital IQ.

Going by the magic formula criteria, none of these companies meets both standards, but R.R. Donnelley and Pitney Bowes both offer the formula's desired 10% earnings yield. None of the listed companies offers the formula's desired 25% ROA.

Waste Management (NYS: WM) has operations that include trash collection, recycling, and landfill management. It is the largest trash and environmental services company in North America, beating out Republic Services, Waste Connections, and medical-waste manager Stericycle. One thing that is particularly appealing about Waste Management's recycling business is its ability to collect profits for both gathering and reselling recycled goods. It has also been able to use landfills to generate natural gas for its trucks and power the creation of disposable trash bins it can sell to consumers. If Waste Management can stand up to competition from companies like Veolia Environnement and Danaher in expanding its international presence, the company has some appealing growth opportunities arising from India's garbage-dumping problem.

R.R. Donnelley & Sons (NAS: RRD) , like other publishers, has struggled with the rise of the Internet. In January, Donnelley was the worst-performing stock on the S&P 500, and shares have lost more than a fourth of their value since last year. While the company's 8.2% dividend yield would otherwise look appealing, investors need to weigh that against the company's ability to rise to the challenges posed by an economy that is not favorable to publishers.

Pitney Bowes (NYS: PBI) used to dominate the mail services industry with machines that could calculate postage so offices could mail packages more conveniently. However, the Internet has brought in new competition, including Stamps.com, which has acquired 80% market share. The company's announcement in 2010 of deals with United Parcel Service and FedEx may have initially carried some promise, but Pitney Bowes has yet to see a turnaround in its falling profits.

Clean Harbors (NYS: CLH) specializes in hazardous waste disposal and serves most of the Fortune 500 companies globally. In addition to its work in hazardous waste, it also works in garbage and recycling management, and it's seeing an increasing amount of business from clean-up projects. Some of its recent clean-up work includes the September 11 attacks, Hurricane Katrina, the BP oil spill, and the recent ExxonMobil spill.

Ritchie Bros. Auctioneers (NYS: RBA) serves a niche market by auctioning off industrial equipment that farmers and businesses use. This sets it apart from other bidding services, preventing it from having to go head to head with businesses like eBay and Sotheby's. While Ritchie Bros. faced some tough times during the credit crisis, it has recently seen some improvement. However, the company's 2011 third-quarter results missed earnings estimates. Fellow Fool Dan Caplinger argues that a possible reason for this shortfall is high crop prices, which give farmers more flexibility to buy new equipment, rather than pursuing the cheaper options offered by Ritchie's auctions.

Foolish bottom line
The key advantage of the magic formula is speedy decision-making. You can run a screen and mechanically buy the stocks, then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), because you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year in order to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.

While this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his magic formula can significantly outperform the market.

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At the time this article was published Jim Royal, Ph.D. does not own shares of any company mentioned.The Motley Fool owns shares of Waste Management and Clean Harbors. Motley Fool newsletter services have recommended buying shares of Waste Management and Ritchie Auctioneers, as well as creating a write covered strangle position in Waste Management. The Motley Fool has a disclosure policy.
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